Why you don't get tax advice from your neighbor - Court Cases
Estate loss of Bernie Madoff assets
After taxpayers death, estate discovered that large assets held by Bernie Madoff was worthless. Estate took a theft loss for the worthless investment. IRS disagreed saying the loss was incurred by the LLC who owned the assets not the estate. Tax Court disagreed. (Est of Heller, 147 TC No11)
Developer sale of land – ordinary income
Developer subdivided land, built access road and sold various lots. They reported the losses as ordinary. After changes in county regulations made it more expensive to develop, sold the remaining lots. Court said they held the sales in ordinary course of business and considered ordinary income (Boree, 11th Cir)
Deposit kept on a cancelled sale of business property – Ordinary income
Sellers deal to sell hotel fell through. They kept the 10 million deposit per agreement terms and reported it as a capital gain. Tax court disagreed, saying the underlying asset would have to be a capital asset and the hotel did not qualify as such. Option payment gain was ordinary (CRI-Leslie, LLC, 147 TC No 8)
Pastor’s vow of poverty doesn’t make his income exempt from tax.
Church paid the pastors personal expenses after he gave all his assets to the church . IRS considered the payment of personal expenses income subject to income tax and SECA tax. Tax Court agreed (White, TC Memo 2016-167)
Shareholder advances to wholly owned corporation
Shareholder advanced money to his wholly owned corporations. He had no loan agreement, promissory note, interest calculation or repayment date. Corporation also paid his mortgage and car payments and did not pay him a salary. Shareholder performed substantial services for the corporation. IRS recharacterized payments as salary. Tax Court disagreed (Scott Singer Installations, TC Memo 2016-161)
Celebrity Estate Tax Cases
Valuation of estate assets create an opportunity for IRS to challenge the valuation. Both Michael Jackson estate and the Whitney Houston estate. For the Michael Jackson estate, the issue is the value of his name and image at his death. For the Whitney Houston estate, the issue is the value of her record and performance royalties.
IRS Rejects taxpayers offer to settle tax debt
Taxpayer failed to file returns and pay taxes for 5 years. Owed 15.5 million. Offered IRS $500,000 to settle debt. IRS said no, he had a history of egregious noncompliance with the federal laws. Appeals court agreed (Hauptman, 8th Cir)
Over contributing to IRA creates fines
Taxpayer sold their house and each contributed $200,000 into their IRAs. A few years later, they discovered this error, notified the IRS and withdrew the excess contributions. They agreed they owed a 6% fine on the excess for 2 of the 3 years claiming that they withdrew the excess before the tax return for the 3rd year was due. Appeals court disagreed (Wu, 7th Cir.)
Paying someone else’s mortgage doesn’t get you an interest tax deduction
Boyfriend paid cash to his girlfriend (who he lived with). He claimed that it was so she could pay her mortgage and then took a deduction for mortgage interest on his tax return. Tax Court denied the deduction. He was not liable for the mortgage, he was not on title to the property and bore no benefits of homeownership. (Jackson, TC Summ. Op. 2016-33)
Suing your employer for sending you a 1099-Misc instead of W-2
Employee sued former employer for fraudulently sending him a 1099-Misc and not a W-2. He said his employer willfully misrepresented his worker status. District court through the case out saying that even if the employer intentionally filed the wrong form, the form showed the correct amount paid to the worker. (Liverett v Torres Advanced Enterprise Solutions LLC, DC Va)
Paying Bonus to your kids
Couple with many businesses hired their children (ages 8-13 yrs) to do various office tasks. They were paid small wages during the year and a large bonus at year end. The bonuses were based on year end profits and in one year reached $20k for each kid. Tax court allowed wages through the year but disallowed bonus. (Embroidery Express, TC Memo 2016-136)
Retired Mary Kay Consultant
Mary Kay consultant was previously paid on a 1099-Misc for their commissions. On retirement, the pension benefit was calculated based on commissions made during her working career. The plan was also a non-qualified plan. Taxpayer says the payments were for ending her business. Appeals Court says it’s deferred compensation and subject to self-employment tax. (Peterson, 11th Circuit)
As the 91 year old doctor aged he hired home health care provider to take care of him full-time. This person took advantage of clients age and dementia to have him pay her over 1 million dollars over a two year period. On IRS audit, she claimed they were non-taxable gifts. Tax Court says she exercised undue influence which negated any intent. Income was taxable and she owed self-employment tax on it as well. (Alhadi, TC Memo. 2016-74)
Write off of Work Clothes – again
Ralph Lauren salesperson was required to wear their clothing at work. Tax Court says personal expense - non-deductible (Barnes, TC Memo 2016-79)
Selling Scrap Metal
Sale of scrap metal may not be subject to self-employment tax. ( Ryther TC Memo 2016-56)
Missing K-1 no excuse to not report partnership income
Taxpayer entered into partnership arrangement with individual who managed the business. The business filed its tax return late. Taxpayer filed their tax return and did not include the partnership income on his return. Claimed he had no knowledge of it. Income is still taxable however the penalty may be waived when taxpayer acted in good faith. (Lamas-Ritchie, TC Memo 2016-63)
Attorney’s failure to honor clients IRS levy notice proves costly
Attorney for a client held lawsuit proceeds in their trust account. IRS served attorney a levy on attorney’s client for the funds. Attorney then diverted the funds to his client. District court says the attorney is personally liable to IRS for clients tax bill plus a 50% penalty for not having a valid reason to no honor the levy. (Huckaby, DC, Calif)
Real Estate Broker fee for buying his own house
A real estate broker was paid a fee when he purchased his own house. That fee is taxable but not subject to Self Employment tax – per Tax court (Guarino, TC Summ Op 2016-12)
Paying Wages to your kids
Taxpayer paid wages to her young kids. Her kids were all under the age of 9. They helped with miscellaneous office duties, shredding, mailings, copying. Taxpayer took a 10k deduction. Tax Court found it excessive and denied the deduction. Taxpayer didn’t keep records of their time spent working. She didn’t have timecards or issue W-2’s. She considered it a cash gift to their 529 Plans. The court limited her deduction to $250 per child (Fisher, TC Summ Op 2016-10)
Using IRA to invest in Business
Another court appearance for the misuse of IRA Funds. Taxpayer rolled IRA money over into another IRA and had the Custodian purchase the stock in a new business just being formed by taxpayers. The new business then purchased another business for cash and a note that was guaranteed by IRA owners. The personal guarantee by IRA owners was a prohibited transaction and IRA was terminated. Taxpayer had to pay tax on the full amount. (Thiessen, 146 TC no7)
IRS can force sale of jointly owned residence
Taxpayer owed tax debts from his business. IRS was going to sell the personal residence that was jointly owned by taxpayer and his wife and give ½ of the proceeds to the wife. Wife claimed she had a higher interest in the property because she was younger and had a longer life expectancy. Courts didn’t agree and allowed the sale to go through. (Davis 6th Cir)
Exotic Dancer failed to report all her income
Taxpayer received wages, tips and extra money from offering private dancer and other services. On Audit, IRS discovered the extra money and taxpayer claimed it was a gift from her clients for delivering free services. She was found guilty of filing false tax returns and sentenced to 33 months in jail. Appeals court just affirmed her conviction (Fairchild, 8th Cir)
C Corporation paid bonuses to owners at year end
IRS and Tax Court agreed that the bonuses were really dividends and the deduction was disallowed. Taxpayer received a 20% penalty on top of the tax liability. (Brinks, Gilson & Lione, TC Memo 2016-20)
Write off of work clothes
Bartender wrote off his work clothes. IRS disagreed. Taxpayer was expected to dress all in black. Clothing was high end and could be worn outside of work. Deduction disallowed. Tax Court agreed (Belifa, TC Summ Op 2016-8)
Fixing Charitable Deduction
Family owned a corporation and a partnership. They mistakenly wrote a check out of the corporation to a charity instead of the partnership. When they discovered the mistake, they immediately took steps to address it including contacting the donee and correcting the financial statements. IRS denied the deduction but district court allowed the tax write off. (Green DC Okla)
Trustee made distributions to beneficiaries of a trust leaving the trust with insufficient funds to pay its tax liability. Trustee was made personally liable for the tax debt, including penalties and interest. (Read DC Conn)
Divorce disqualifies ESOP
Couple both work in a chiropractic office and are the sole participants in the company ESOP. The couple divorced with the divorce agreement allocating 50% of the business to each of them. The divorce document was silent on the allocation of the ESOP. Exwife later relinquished her ESOP shares to ex-husband. Tax court said the transfer violated the ESOP rules and disqualified the ESOP. (Family Chiropractic Sports Injury, TC Memo 2016-10)
Taxpayer kept his household goods in storage in the area of his new job for 9 months. Tax court only allowed 30 days. (Parmeter, TC Summ Op 2015-75)
Selling your house and taking the primary residence exemption
Taxpayer sold house and took an installment note for part of the debt. When he filed his taxes, he took the $500k primary residence exemption. A few years later, buyer defaulted and taxpayer reacquired the house. Taxpayer had to pay gains tax on all payments, even the initial 500k exemption. (8th Circuit, DeBough)
Cancellation of Debt
Taxpayer had their car repossessed. Several years later, she received a 1099-C reporting cancellation of debt. (car was sold for less than the loan). IRS said she had income. Tax Court disagreed saying the debt was discharged 36 months after she paid her last payment. (TC Memo 2015-175, Clark)
Loss on sale of Vacation Home not Deductible
Couple had a second home they used with their daughter. Daughter died and the couple couldn’t use the property anymore, so they decided to rent it. They signed a rental agreement with an agent however; the house was never actually rented. Tax Court denied deduction for loss on sale with the view that there was not enough activity to call this a rental. (Redisch, TC Memo 2015-95)
Self-Directed IRA owned company
The company owned by taxpayers Self-Directed IRA paid taxpayer a salary for managing the company. This salary was a prohibited transaction making the IRA fully taxable.
Renting property to a relative
Couple rented their house to their daughter for $2000 per month. FMV of the rental was $6000 per month. Tax Court denied rental deductions considering this bargain rent as personal use. (TC Memo 2015-181, Okonkwo)
White collar criminal convicted of money laundering, courts took IRA to cover restitution and fines. He gets to pay the tax on the distribution.
In another case, taxpayer directed his IRA to invest in a real estate venture where taxpayer owned 50%. This was a prohibited transaction and opened up IRA to creditors.
Mortgage limits – per house or per individual?
There is a mortgage limit of 1 million that is deductible on Schedule A. The question that came up is that per house or per individual (say two unmarried individuals own a house). Well, per the 9th Circuit court in Voss, it applies per individual and not per house. So two unmarried individuals can own a house and have 2 million in debt (1 million each) and have it deductible.
Living at the Casino – still not professional gambler
Taxpayer had a full time job as a NJ Tunnel Agent, he had no permanent address and spent his off duty time at the casino and staying in their rooms. Taxpayer deducted his meal and other gambling costs on Schedule C. Tax Court says not a professional gambler. He did not conduct his business in a business like manner. (TC Memo 2015-128, Boneparte)
A couple pleaded the 5th when asked about their foreign bank accounts. A few different Circuit courts said no to this.
International Flight Attendant – earnings in international air space
District Court decided that wages for flights in international air space don’t qualify for the foreign earned income exclusion. However, pay for flights over foreign countries airspace does qualify.
Start-up Expenses aren’t deductible until business is operating as a going concern
Taxpayer had fulltime job and spent off hours visiting construction sites, handing out cards. He had a website but no clients or income. He didn’t bid on jobs. Tax Court says he cannot deduct his expenses because the business was not a going concern. (TC Memo 2015-28, Tarighi)
Alimony – Homeschooling
Taxpayers divorce agreement stated that Alimony would be reduced if wife stopped homeschooling children and got a job. IRS denied the deduction as the payment was tied to a child contingency. Tax Courts disagreed and said the payment was tied to the ex-spouse’s return to work. (Wish TC Summ OP 2015-25)
Paying Someone Else’s Expenses
Taxpayer transferred funds to brothers business and paid expenses on behalf of his brothers business. He also took a deduction for them on his Schedule C. Tax Court denied expenses. (Espaillat, TC Memo 2015-202)
Loans to Friends
Tax Court Memo 2015-191 says that taxpayer who loans money sporadically to friends is not in the lending business. He only made 12 loans in 5 years and did not conduct proper due diligence or keep proper records.
Foundation benefits single family – not a tax-exempt charity
Taxpayer died and executors of his estate set up a organization to award scholarships in the performing arts to students of Hungarian descent. IRS later learned that the organization provided scholarships to only nieces and nephews of the decedent. Their tax exempt exemption was revoked.
Charitable Donation of Property – denied by Tax Court
Veterinarian donated fossils to a charity. He received an acknowledgement letter but it did not contain all the correct verbiage. He also did not get a appraisal of the items. He valued them $100,000. Donations of stuff $5,000 and more must have an independent appraisal. Tax court denied the deduction (Isaacs, TC Memo 2015-121)
Charitable Donation of Property – Denied by Tax Court
Couple donated $37,000 worth of property to four charities. Did not receive contemporaneous written ackowledgments or an appraisal for the donation valued over $5,000. Tax Court denied their write off and slapped them with a 20% negligence penalty. (Kunkel, TC Memo 2015-71)
Stock worthless because of Corporate Fraud
Taxpayers purchased millions of share of a public company in the open market. The stock later became totally worthless due to fraud committed by company executives. Taxpayers though they should be able to consider the stock loss a theft loss. Tax Court said if they purchased the stock from the frauster, then it could be a theft loss, but they purchased in the open market. (Greenberger DC Ohio)
Year End Bonuses
Taxpayer paid themselves a year-end bonus of$ 815,000. The business didn’t have enough in the bank account to cover the cashing of this check so the owner just endorsed it over and it was recorded as a loan to the company. Tax Court denied the write-off because it wasn’t a cashable check when the owner received it.
Taxpayer’s used life insurance proceeds from their son death to fund a non-exempt irrevocable trust to give scholarships in his honor. When the trust gave out scholarships, the taxpayers took a charitable deduction. Tax Court denied the deduction because the trust made the payments and the taxpayers didn’t own the trust.
Taxpayer was hurt and collected disability. Insurance company gave him a W-2. He claimed it was tax-free. Company paid the disability insurance policy not the employee – distributions were taxable to the employee.
Airline Ticket for opening up an account – is taxable
Taxpayer received an airline ticket for opening up a bank account. The bank gave him a 1099-Misc for the value of the ticket and treated the ticket value as interest. Tax court agreed. However, note that mileage earned and points earned on credit card purchases are still not taxable.
Online Charity – a Sorority
A group organized a charity to operate a nationwide virtual sorority for students. The majority of their events and activity took place over the internet. IRS says – not an exempt organization because of the lack of face-to-face interaction among its members.
Hardship distributions from retirement plans before Age 59 ½.
Taxpayer lost his job and took distributions from his retirement plan to pay the mortgage and support his family. There is a list of exceptions to the 10% penalty of taking a early distribution from your retirement. Hardship is not one of them. Tax Court has sided with IRS on this. IRS has a chart of what does qualify for penalty exception.
IRS challenged taxpayer who paid her employees (her kids – Aged 7, 8, 12) with pizza. The kids would come into the office after school and do various office tasks. She filled out W-2’s and other payroll reports, however never really issued the kids a paycheck. Court sided with IRS and disallowed the pizza payments disguised as wages.
Taxpayer claimed business expenses on their return for Vehicle Expenses, travel, meals, entertainment and rent totaling over $28,000. Taxpayer was a sole-proprietor but did not have any income from this activity. Tax court found that taxpayer did not carry on the activity in a businesslike manner and denied all the deductions. What are some things the Courts noticed that taxpayer did not do? Hire a coach to improve performance or enter tournaments.
Medicare taxes paid or withheld from your paycheck are not considered a medical expense.
To deduct gym memberships, health foods and supplements as medical expenses, taxpayer must prove that they spent more than they would normally have spent for a verifiable and credible medical reason. IRS can expect you to provide statements, invoices, and other documentation to substantiate your expenses.
The penalty on early distributions from a qualified retirement plan can be offset by medical expenses. (The penalty not the tax)
Taxpayer could not substantiate the medical expenses and were not only issued the 10% early distribution penalty but also the 20% accuracy related penalty.
Travel & Business Use of Home Expenses
Taxpayer had a business and worked out of her home. She tried to deduct her vacation because she needed to get away from the business and considered it a business expense. The deduction was denied and considered a personal expense.
Business use of Home and Vacation Home Rental
Taxpayer used the 1st floor of their home on a regular basis for their business. They couldn’t substantiate the use as regular and exclusive and had their deduction denied.
A different taxpayer had a motor home used for both personal and business. However, they could not substantiate the business use. They needed to prove the “exclusively and regularly” elements of business use and could not. The motor home qualified as a 2nd home, however they had more than 14 days of personal use. Therefore, deduction was denied.
Taxpayer used a number of vehicles that he owned in his real estate business. He reported that they were all 100% business use. One of the vehicles was a Hummer which taxpayer elected to expense with a Section 179 election. He considered the Hummer to be used primarily for advertising but actually driven for business minimally. When an asset is used for business has the business use of the asset drop below 50%, depreciation and Section 179 may need to be recaptures to reflect the change in business use. Taxpayer could not provide the records to support business use and lost deduction.
Real Estate – Rental
Taxpayer with numerous rental properties elected to combine them for reporting purposes, thereby being able to deduct the losses generated by them. However, to make this election, taxpayer needed to spend 750 hours or more on the properties. They did not keep a log to substantiate their claim and when they tried to recreate it, the hours did not meet the 750 hour requirement. Taxpayer lost the deduction on their return.
In another case, taxpayer had numerous properties but did not elect to group them and consider them a business. However, they tried to deduct expenses for these properties as trade or business expenses but because they did not group them, they had to meet the 750 hour rule on each property. They did not and lost the rental deduction.
Taxpayers’ mortgage on her property was greater than the fair market value of it. Tried to rent it but ended up walking away and letting the bank foreclose on it. She took an ordinary loss for this property on her return. However, a foreclosure is considered a sale and she needed to report income as the difference between the foreclosure amount and her basis. She ended up reporting a capital gain instead of a loss on this property.
Basis of Stock Sales
Taxpayer had about 20 different stock sales and had to substantiate his cost. He tried to use the “aggregate basis theory” however the courts didn’t allow and sided with IRS that basis for the stocks was zero.
Taxpayer received a payment from a lawsuit involving his attempt to acquire property and build a condominium on it. Tax Court found that the income was ordinary and not capital gain based on the taxpayer's everyday business of property development.
Taxpayer owned a company created from nothing by his son. His son cultivated all the relationships for the business but did not have an employment contract. When the father passed away, IRS and father's estate had a disagreement over the value of the company. IRS had a larger value on it where estate had a lower value. Since the son did not have an employment contract with the company, he could take the business to a competitor. IRS lost their higher valuation.
Non-Profit Beauty Pageant
A non-profit organized a local beauty pageant (not in Rochester ) and awarded a scholarship to the winner. The winner had to sign a contract and perform services for this non-profit after winning. This made the scholarship taxable income.
Non-profit also lost its tax exempt status because organizing and operating pageants was not a valid 501C3 purpose.
Home Office Deduction
One of the qualifications for having a home office deduction is that the home office needs to be used exclusively for the business. Taxpayer had a home office in a small studio apartment and had to walk through the office to reach the bedroom. This small amount of personal use did not exclude the home office deduction per Tax Court.
Taxpayer passed away with part of his estate including an investment with Bernie Madoff (before the scam was found out). Once the scam came to light, the estate applied for a refund by amending the estate return, removing the Bernie Madoff investments. IRS disagreed saying at the time of death and estate return valuation, the scam was not discovered yet. Tax Court is still deciding.